Why the sun has not set on luxury stocks

Luxury stocks have been getting a lot of attention of late, with softness in the market being largely driven by the continued weakness of the Chinese economy – by Mark Nelson

 
The current predicament raises two big questions for investors – is there a long-term structural issue in China and, if that is not the case and it is just a cyclical downturn, when will the good times start to flow again?

Currently at Killik & Co, we are taking a defensive approach to the sector due to the current uncertain backdrop. We currently own shares in EssilorLuxottica which is a unique combination of a medical devices business (lenses) and a luxury goods one (frames) and plays to the structural trend of the growing need for eyecare due to the increasing prevalence of eye conditions amongst the growing population due to changing lifestyles and demographics. Management has stated that 75% of revenues are vision care related and therefore less discretionary in nature. We have also been long term holders of shares in LVMH, which we continue to hold. It is the largest company in the sector, one of the highest quality, and has the most diversified business mix. Whilst our positioning is defensive, investors who feel the turnaround might be more imminent would likely want to be in some of the names which have suffered most in the recent downturn, such as Kering and Burberry.

Despite our relatively defensive stance, our opinion remains that the slowing luxury demand in China is not structural. Many like to draw comparisons between China and Japan in the 1980s, but while there are similarities such as ageing populations, there are some key differences too. For a start, there remain hundreds of millions of people who have not yet reached middle-class status in China, and it is this emerging middle class that has been a key driver of luxury goods demand.

China is an ambitious nation, with grand geopolitical goals which we believe are more likely to be achieved with a prosperous population and a growing middle class. We therefore expect the Chinese government to do whatever it takes to provide the economy with the necessary support in pursuit of these goals.

The second question on when exactly things will turn around in the Luxury sector is much trickier to predict. LVMH’s management recently shared their reluctance to call a bottom and that is understandable given the current climate. However, there are early causes for optimism.  China does seem to be making significant attempts to re-ignite the economy via stimulus measures. Additionally, the easing of the interest rate cycle in the developed West should be supportive of increased demand for those markets. Finally, Trump’s election in November’s US election is being seen as a positive for the sector overall, with lower taxes and a currently buoyant stock market both positive for the wealth effect and in turn luxury demand in the United States.

Finally, lower company valuations in the sector come with increased talk of potential M&A activity. Moncler was rumoured to be interested in acquiring Burberry for example. However, we think large deals are unlikely given the potential for regulatory challenges, at least if the Capri and Tapestry deal is anything to go by

 
Mark Nelson is Senior Equity Analyst at Killik & Co